Russia’s futuristic arms buildup is totally tanking

The Russian economy may have stabilized in 2015, benefitting from the devaluation of the ruble and the stabilization of oil prices. But it’s certainly not strong enough to satisfy all of Russian President Vladimir Putin’s ambitions.

According to the Associated Press, the Russian military’s $400 billion modernization effort–which includes the construction of thousands of futuristic “Armata” tanks, among other initiatives–is coming under pressure after falling oil prices and Western sanctions have taken a huge bite out of government revenues.

The tanks, which Russian officials claim are 15-20 years ahead of Western designs, include a remote control turret, and is “as pleasant and easy to drive as a modern SUV.” Russian military planners also hope that in the near future, the tank “evolves into a fully robotic vehicle that could operate autonomously on the battlefield,” according to the AP.

But even as Putin recently increased his country’s military budget by 33% in order to help fund the modernization effort, analysts have said that it is inevitable that he will have to reverse that decision and spend less on the military as the Russian economy is expected to continue to contract through the end of next year.

Will American and European taxpayers save Ukraine from default?

Despite an ostensible ceasefire between Ukraine and Russia, low level fighting continues between the Eurasian rivals. But Ukraine is about to open up a second, potentially more dangerous, front in this conflict–this time with its foreign creditors.

On Tuesday, the Ukrainian Parliament passed a bill that would allow the government to default on payments to foreign creditors, amid negotiations to restructure its increasingly unsustainable debt.

So, does this mean that the Ukraine is going bankrupt? Most outside analysts agree that Ukraine can’t pay back what it owes. But as we know from the situation in Greece, just because everyone agrees a country can’t make good on their debts doesn’t mean it will default.

Take, for instance, the example of Mexico. In 1995, the U.S. government, in conjunction with the IMF, the Bank of International Settlements, and private banks, orchestrated a $50 billion bailout for Mexico, which was undergoing a severe recession as well as a debt and currency crisis. Then Treasury Secretary Robert Rubin worried that letting Mexico default would spark a financial crisis that could spread to other nations. Other supporters of the bailout pointed to the deep economic ties between the United States and Mexico, arguing that hundreds of thousands of U.S. jobs could be lost if Mexico were allowed to default.

When it comes to the Ukraine, people like financier George Soros have argued that the international community, and specifically Europe, should invest at least $50 billion on top of the $17 billion the IMF has already offered to help the nation stabilize its economy and reform its bureaucracy. If Ukraine were able to successfully go through with such reforms, such as radically reducing the size of its public sector, it could very well lead to the sort of economic growth that would enable it to pay back its benefactors. But as Soros admits, Ukraine’s track record of using international loans to spur reform is spotty. And unlike in the case of Mexico, Ukraine doesn’t have large deposits of oil to use as collateral.

Another option to saving Ukraine from financial ruin would be to force private creditors to forgive its outstanding debt. That’s the approach former Treasury Secretary Larry Summers advocated in an op-ed published on Monday. “The case for debt reduction is as strong as any that I have encountered over the past quarter century,” Summers writes.

Summers argues that Ukraine cannot possibly pay what it owes, and that its troubles are not just a result of creditors over-lending and Ukraine over-borrowing. Instead, Russian aggression is also to blame. Finally, Summers writes, “[Ukraine] has shown real political courage in combating corruption and moving aggressively to curb energy subsidies that generated vast waste. Ukraine has done more in the past 12 months to reform its subsidies than most nations do in 12 years.”

But how exactly will the international community force private creditors, composed mostly of large investment companies like Franklin Templeton, to accept losses on Ukrainian sovereign debt? Summers is less specific on this question, but he more or less suggests that the international community support Ukraine in a high-stakes game of chicken:

It should be unacceptable to taxpayers around the world that their money be put at risk on loans to Ukraine in order that plans be made to pay back creditors in full. The IMF and national authorities should call out the recalcitrant creditors on their irresponsible behaviour. If necessary, Ukraine should be prepared to go into default and not meet its obligations, while at the same time the international community should make clear that it will continue to provide support to Kiev. In the context of these steps, creditors will have little choice but to accept the economic reality of the situation.

The vote taken in the Ukrainian parliament on Tuesday is the first step in initiating this process. But will Ukraine’s creditors budge? The recent drama over Argentina’s debt restructuring, in which a group of bondholders used the U.S. court system to block a restructuring deal and insisted on being paid in full, casts doubt on this scheme.

Ukraine’s creditors surely realize that they have more leverage in Eastern Europe than they’d have even in a place like Argentina. There’s support on both sides of the aisle here in America for standing tall against Russia. Meanwhile, the U.S. hasn’t thought twice about spending an estimated $8.6 million per day—more than $2 billion total so far—in its fight against ISIS. That’s money it has no chance of being repaid, whereas any loans it makes to Ukraine very likely could be. Ukraine’s lenders are certainly paying close attention to America’s willingness to spend big to project its power in strategically important corners of the globe.

Meanwhile, even Summers’ hardball strategy would require the international community to prop up Ukraine while it negotiates with creditors. The international community may be able to shame lenders into taking losses in order to support Western values. But Big Finance hasn’t proven too susceptible to public shaming lately, so taxpayers in the U.S. and Europe shouldn’t be surprised if they are forced to swerve first.

Russia’s economy: In better shape than you might think

During President Obama’s State of the Union address earlier this year, he boasted about the effectiveness of Western sanctions against Russia, claiming that the Eastern European nation’s economy was “in tatters.”

The president certainly had incentive to pump up the sanctions he helped enact. But at a panel discussion on the future of the Russian economy on Wednesday at the Milken Institute Global Conference, Russia experts and investors in the Russian economy vehemently disagreed with his analysis.

Panelists argued that the Russian recession is largely a result of a collapse in oil prices rather than Western sanctions. Meanwhile, the ruble has stabilized after falling sharply last year and the Russian stock market has recovered more than 20% in 2015.

Billionaire investor David Bonderman argued that Western sanctions, though much lighter than those imposed on countries like Iran, are actually creating opportunities for investment in Russia. “The market has fallen a long way, and there’s a shortage of capital,” he said. “Returns tend to be higher where either the troops are in the street or prices are low.”

Retailers like Russian supermarket Lenta, which Bonderman has a stake in, are seeing higher margins absent Western competition, and demand for staples like groceries remain strong. Russian-born investment banker Ruben Vardanyan pointed out that the collapse of the ruble left much of the economy untouched, with roughly 90% of the population not inclined to buy imported goods. And that population, Vardanyan points out, has only increased its support for Vladimir Putin in the months following the imposition of sanctions.

The panel uniformly condemned U.S. policy towards Russia as ineffective and short-sighted. Susan Eisenhower, chairman and CEO of The Eisenhower Group, a consulting firm, argued that isolating Russia, even as a punishment for breaking international law, “isn’t in the United States’ interest.” She pointed to the increased risk of nuclear weapons proliferation in a world where the United States and Russia aren’t communicating.

Eisenhower argued for a reset of U.S.-Russia relations, first by appointing a special envoy to Russia to restart a dialogue that can help resolve the dispute over Crimea.

Bonderman said that U.S. policy towards Russia is simply pushing the country into the arms of China, a relationship he argued is counter to the desires of the Russian people and the interests of the United States. “The Russian people want to be Western; to force them to the east is unnatural,” he said.

To be sure, investors in Russia, like those who sat on the panel at the Milken Conference, would benefit from a lifting of sanctions. But the surge in Russian markets and Putin’s popularity suggests that the Russian economy isn’t as bad as we thought.

The similarities are obvious: both Putin and Hitler annexed neighboring territories on the basis of the ethnicity of their inhabitants, and both leaders used highly charged racial rhetoric to boost support for and benefit politically from those incursions. But how similar are Putin’s plans to Hitler’s in the 1930s, and how will the market and global economy react if Putin steps up the aggression in Eastern Europe?

Todd D. Mariano, director and senior policy analyst at Renaissance Macro Research, dove into the issue in a report to clients last week, and he argues that while there are strong similarities between Putin’s behavior now and Hitler’s actions back then, investors have less to worry about than they might first suspect.

Mariano argues that while Hitler’s annexation of neighboring regions was part of a drive for territorial expansion—one that he explicitly outlined in print a decade before he set out to realize it—Putin’s moves in recent months have been reactive in nature. Hitler’s imperial moves: the militarization of the Rhineland, the implementation of a plan to allow Germany to survive a wartime blockade, and the successive invasions of Czechoslovakia, Poland, and France, were taken with little regard to events going on in those countries. The events this year in the Ukraine, however, “were not of Putin’s design,” Mariano writes. Unlike Hitler, Putin merely reacted to unrest in Ukraine that, while certainly encouraged by Russia, was by no means solely a result of Russian machinations.

In other words, Putin and Hitler are similar in how they justify their actions, but Putin is much less ideologically driven and more opportunistic than Hitler was. “We don’t believe Putin shares or is capable of Hitler’s massive territorial ambitions,” writes Mariano. “Drawing parallels between the two minimizes the scale of what Nazi Germany inflicted on the world. Putin does not respect Ukraine’s sovereignty, but that is not the same as Hitler’s megalomania and it beggars the analogy.”

For investors, the question over whether to be spooked by Putin’s actions goes beyond any similarities between his plans and those of Hitler during the 1930s. After all, Putin needn’t launch World War III to rattle markets. But Mariano points out that even as Hitler sent his army through Austria and Czechoslovakia in 1938 and 1939, the Dow was in “upswing mode” as it recovered from the crash associated with the so-called “recession within a depression” of 1937:

Stocks fell upon Hitler’s invasion of France in 1940, but not to the same degree that they did during the 1937 recession. Indeed, a 2011 study by economists Massimo Guidolin and Eliana La Ferrara of 101 internal and international conflicts from 1971 through 2004 found that markets are most negatively affected by conflicts in the days and weeks leading up to the formal outbreak of war, because of the uncertainty associated with those periods. After conflict breaks out, however, markets on average perform better.

This comes as cold comfort for the citizens of Ukraine caught in the conflict. But there’s little reason to think of Putin as the next Hitler, and even less reason to think that markets, in the long run, will suffer from the Russian president’s opportunism.

The Obama administration followed through on past promises to escalate sanctions against Russia over the country’s continued involvement in the political turmoil in Ukraine.

The U.S. Treasury Department announced a fresh set of sanctions Wednesday aimed at Russia’s financial, energy and defense industries on top of an earlier round that targeted specific Russian citizens with U.S. travel bans and frozen assets. The latest penalties go after two major Russian energy outfits, Novatek and Rosneft, as well as two leading Moscow financial institutions, Gazprombank and VEB. Officials are limiting those companies’ access to the U.S. capital markets while also targeting eight Russian arms firms as well as several other individuals and companies connected to the separatist uprising in Ukraine.

“Because Russia has failed to meet the basic standards of international conduct, we are acting today to open Russia’s financial services and energy sectors to sanctions and limit the access of two key Russian banks and two key energy firms to U.S. sources of financing, and to impose blocking sanctions against eight arms firms and a set of senior Russian officials,” David Cohen, the Treasury’s Under Secretary for Terrorism and Financial Intelligence, said in a statement. ”

Meanwhile, European Union leaders are also meeting to discuss their own potential punishments for Russia. Bloomberg reports that the EU’s response could include cutting off Russia’s access to the European Bank for Reconstruction and Development as well as the European Investment Bank.

In China-Russia gas deal, why China wins more

To the casual observer, it’s easy to doubt that China and Russia would have ever struck a natural gas supply and purchase deal during Russian President Vladimir Putin’s meeting with Chinese President Xi Jinping in Shanghai last month. After all, countless summits between Chinese and Russian leaders have come and gone with no final agreement signed for the long-discussed plans to ship more Russian gas to China. However, Putin and Xi finally ended an energy courtship, agreeing to a $400 billion deal for the delivery of 38 billion cubic meters of natural gas to China starting in 2018.

Long before the Chinese and Russian leaders on May 21 toasted their supply contract, the two countries had viewed each other as attractive natural gas partners. Russia regarded tapping into the Chinese market as essential to its plans to diversify its exports away from Europe, where natural gas demand is projected to grow at a substantially slower pace than in China. Meanwhile, the surge in China’s natural gas demand in recent years made the Chinese eye their northern neighbor, the world’s largest natural gas exporter, as an important source of supply to fill the gap between China’s domestic natural gas production and consumption.

Developments in the months leading up to the Shanghai summit may have provided Russia and China with added incentives to get serious about a natural gas marriage. For Russia, the new imperative is the country’s increased isolation from the United States and Europe in the wake of Russia’s annexation of Crimea and the resulting Western sanctions.

Europe’s renewed interest in finding alternatives to natural gas supplies from Russia, and the calls by U.S. policymakers and pundits for Washington to expedite the process for granting LNG export licenses and lift the virtual ban on crude oil exports to help wean Europe off Russian energy, undoubtedly made signing a gas pact with China even more appealing to Moscow.

For China, the country’s poor air quality and it’s “war on pollution” declared by Premier Li Keqiang in March likely increased the desirability of Russian natural gas. Indeed, the Chinese government’s announcement in April that the country aims to more than double the country’s natural gas consumption from 170 bcm in 2013 to 400-420 bcm in 2020 means China now needs Russian gas more than ever.

The major obstacle that Russia and China encountered on past attempts to make it to the altar was price. Russia did not want to sell gas to China at a price lower than it commanded in Europe, its largest customer. Meanwhile, China did not want to buy gas at a higher price than it paid Turkmenistan, its largest supplier of natural gas.

Although the Russians and the Chinese have come to a meeting of the minds on price, they are treating it as a commercial secret. Consequently, there has been much speculation by outside analysts about the price implied by the $400 billion contract and what it says about which country got the better deal. A back-of-the-envelope calculation yields an implied price of $350 per thousand cubic meters, which is close to what the Chinese are understood to have paid for gas from Turkmenistan last year. This estimate fits with the consensus among many outside observers in the lead up to the summit that Chinese had the upper hand due to Russia’s strained relations with the U.S. and Europe and the number of natural gas producers eager to supply the Chinese market.

That said, we do not know the pricing formula, the base number to be plugged into that formula or how a variety of other issues on the negotiating table – such as the apparent lack of upstream access in Russia for the Chinese, a rumored prepayment from the Chinese to the Russians, a Russian proposal to exempt gas sent to China from a mineral extraction tax, a Chinese proposal to exempt Russian supplies from an LNG import tax, and expectations about the pace of natural gas price reform in China – influenced both countries decisions about price.

It is also important to note that this is not a marriage among equals. The natural gas supply agreement is the third time in the past decade that the Russians have brokered a multi-billion dollar energy deal with the Chinese in a time of need. In 2005, the China Development Bank and the Export-Import Bank of China were lenders of last resort to Rosneft, providing the Russian national oil company with a $6 billion oil-backed loan to help fund the purchase of the main production asset of a private Russian oil company, Yukos.

Four years later, the China Development Bank extended oil-backed loans worth $25 billion to Rosneft and Transneft, the state-owned pipeline operator, when oil prices collapsed and credit crunch during the global financial crisis left both Russian companies in a world of hurt. These deals have not only deepened bilateral energy relations, but also underscored a shift in power in the relationship away from Russia and toward China.

Regardless of which country may have conceded more, both countries can present themselves as winners to domestic and international audiences. The gas deal signifies that the China-Russia energy relationship is starting to live up to its full potential. Russia, which was China’s fourth largest crude oil supplier in 2013, is poised to become a major source of natural gas imports for its southern neighbor. This arrangement should provide Russia with greater security of demand and China with greater security of supply in the long-term. In the short-term, the main benefits of the gas agreement are political. Russia can claim a powerful friend in China, and China can point to another indicator of its growing economic and political clout on the world stage.

Erica Downs is a fellow in the John L. Thornton China Center at Brookings Institution. She focuses on the international expansion of Chinese companies and China’s energy and foreign policies as well as government-business relations in China, and was previously was an energy analyst at the CIA.